Moving averages are a frequently used technical indicator in forex trading, especially over 10, 50, 100, and 200 periods. MAs are used primarily as trend indicators and also identify support and resistance levels. The two most common MAs are the simple moving average (SMA), which is the average price over a given number of time periods, and the exponential moving average (EMA), which gives more weight to recent prices.
Moving Average Trading Strategy
This moving average trading strategy uses the EMA, because this type of average is designed to respond quickly to price changes. Here are the strategy steps.
- Plot three exponential moving averages – a five-period EMA, a 20-period EMA, and 50-period EMA – on a 15-minute chart.
- Buy when the five-period EMA crosses from below to above the 20-period EMA, and the price, five, and 20-period EMAs are above the 50 EMA.
- For a sell trade, sell when the five-period EMA crosses from above to below the 20-period EMA, and both EMAs and the price are below the 50-period EMA.
- Place the initial stop-loss order below the 20-period EMA (for a buy trade), or alternatively about 10 pips from the entry price.
- An optional step is to move the stop-loss to break even when the trade is 10 pips profitable.
- Consider placing a profit target of 20 pips, or alternatively exit when the five-period falls below the 20-period if long, or when the five moves above the 20 when short.
Forex traders often use a short-term MA crossover of a long-term MA as the basis for a trading strategy. Play with different MA lengths or time frames to see which works best for you.
Moving Average Envelopes Trading Strategy
Moving average envelopes are percentage-based envelopes set above and below a moving average. The type of moving average that is set as the basis for the envelopes does not matter, so forex traders can use either a simple, exponential or weighted MA.
Forex traders should test out different percentages, time intervals, and currency pairs to understand how they can best employ an envelope strategy. It is most common to see envelopes over 10- to 100-day periods and using bands that have a distance from the moving average of between 1-10% for daily charts. If day trading, the envelopes will often be much less than 1%. On the one-minute chart below, the MA length is 20 and the envelopes are 0.05%. Settings, especially the percentage, may need to be changed from day to day depending on volatility. Use settings that align the strategy below to the price action of the day.
Ideally, trade only when there is a strong overall directional bias to the price. Then, only trade in that direction. If the price is in an uptrend, consider buying once the price approaches the middle-band (MA) and then starts to rally off of it. In a strong downtrend, short when the price approaches the middle-band and then starts to drop away from it.
Once a short is taken, place a stop-loss one pip above the recent swing high that just formed. Once a long trade is taken, place a stop-loss one pip below the swing low that just formed. Consider exiting when the price reaches the lower band on a short trade or the upper band on a long trade. Alternatively, set a target that is at least two times the risk. For example, if risking five pips, set a target 10 pips away from the entry.
Moving Average Ribbon Trading Strategy
The moving average ribbon can be used to create a basic forex trading strategy based on a slow transition of trend change. It can be utilized with a trend change in either direction (up or down).
The creation of the moving average ribbon was founded on the belief that more is better when it comes to plotting moving averages on a chart. The ribbon is formed by a series of eight to 15 exponential moving averages (EMAs), varying from very short-term to long-term averages, all plotted on the same chart. The resulting ribbon of averages is intended to provide an indication of both the trend direction and strength of the trend. A steeper angle of the moving averages – and greater separation between them, causing the ribbon to fan out or widen – indicates a strong trend.
Traditional buy or sell signals for the moving average ribbon are the same type of crossover signals used with other moving average strategies. Numerous crossovers are involved, so a trader must choose how many crossovers constitute a good trading signal.
An alternate strategy can be used to provide low-risk trade entries with high-profit potential. The strategy outlined below aims to catch a decisive market breakout in either direction, which often occurs after a market has traded in a tight and narrow range for an extended period of time.
To use this strategy, consider the following steps:
- Watch for a period when all of (or most of) the moving averages converge closely together when the price flattens out into sideways range. Ideally, the various moving averages are so close together that they form almost one thick line, showing very little separation between the individual moving average lines.
- Bracket the narrow trading range with a buy order above the high of the range and a sell order below the low of the range. If the buy order is triggered, place an initial stop-loss order below the low of the trading range; if the sell order is triggered, place a stop just above the high of the range.
Moving Average Convergence Divergence Trading Strategy
The moving average convergence divergence (MACD) histogram shows the difference between two exponential moving averages (EMA), a 26-period EMA, and a 12-period EMA. Additionally, a nine-period EMA is plotted as an overlay on the histogram. The histogram shows positive or negative readings in relation to a zero line. While most often used in forex trading as a momentum indicator, the MACD can also be used to indicate market direction and trend.
There are various forex trading strategies that can be created using the MACD indicator. Here is an example.
- Trade the MACD and signal line crossovers. Using the trend as the context, when the price is trending higher (MACD should be above zero line), buy when the MACD crosses above the signal line from below. In a downtrend (MACD should be below zero line), short sell when the MACD crosses below the signal line.
- If long, exit when the MACD falls back below the signal line.
- If short, exit when the MACD rallies back above the signal line.
- At the outset of the trade, place a stop-loss just below the most recent swing low if going long. When going short, place a stop-loss just above the most recent swing high.
Guppy Multiple Moving Average
The Guppy multiple moving average (GMMA) is composed of two separate sets of exponential moving averages (EMAs). The first set has EMAs for the prior three, five, eight, 10, 12 and 15 trading days. Daryl Guppy, the Australian trader and inventor of the GMMA, believed that this first set highlights the sentiment and direction of short-term traders. A second set is made up of EMAs for the prior 30, 35, 40, 45, 50 and 60 days; if adjustments need to be made to compensate for the nature of a particular currency pair, it is the long-term EMAs that are changed. This second set is supposed to show longer-term investor activity.
If a short-term trend does not appear to be gaining any support from the longer-term averages, it may be a sign the longer-term trend is tiring out. Refer back the ribbon strategy above for a visual image. With the Guppy system, you could make the short-term moving averages all one color, and all the longer-term moving averages another color. Watch the two sets for crossovers, like with the Ribbon. When the shorter averages start to cross below or above the longer-term MAs, the trend could be turning.
The Bottom Line
There are multiple ways to use a moving average as part of a forex trading strategy. Moving average trading indicators can be used on their own, or as envelopes, ribbons, or convergence-divergence strategies (to name some examples). Before using any of these indicators or strategies, adjust the settings to verify that the strategies provide favorable results on the forex pairs and time frames you trade. Moving averages are lagging indicators, which means they don't predict where price is going, they are only providing data on where price has been. Moving averages, and the associated strategies, tend to work best in strongly trending markets. (For related reading, see "The Perfect Moving Averages for Day Trading")